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Consumers in the United States, already squeezed by increasing gas prices in 2005, abandoned hope of relief as hurricanes Rita and Katrina swept down on Gulf Coast oil refineries and pushed gas prices above $3 per gallon. For the automotive industry, steady increases in fuel prices, along with regulatory trends and emerging technology, are signaling a moment of intensive change. The automotive industry has historically responded to changes in gas prices, regulatory trends (the tightening of emissions and fuel economy standards), and technological innovations (the advent of microprocessor-based catalytic controllers) with the creation of new segments — first compact cars and hatchbacks, then minivans, and eventually turbocharged SUVs. Responding to today’s challenges won’t be as simple. In effect, there will not be one next big thing that will allow the entire industry to jump on the same bandwagon. Instead, markets will likely evolve in divergent ways as countries choose their own regulations on emissions and fuel taxes, establishing different sets of incentives for automobile producers in each country and thus driving a variety of options for consumers around the world. Companies that hope to thrive in this environment will need the flexibility to realign themselves with many new sets of vehicle designs, power train alternatives, and primary brands.

Already, thanks to gas prices, the dominance of the large gasoline-powered SUV is over. Vehicle sales in the U.S. have shifted to CUVs (cross utility vehicles); between the first quarter of 2004 and the first quarter of 2005, sales of CUVs increased 1.83 percent, fueled by new model introductions, while sales of SUVs dropped 2.18 percent. The popularity of these smaller, less powerful vehicles, with 29 percent more fuel efficiency than SUVs, indicates that consumers are willing to make trade-offs for better mileage.

Looking forward, other implications of this shift could include the ramping up of alternatives to gasoline power trains. Fuel cells are still far off on the horizon, because of a lack of supporting infrastructure and various other technological constraints. Diesel-powered and hybrid (part electric and part gasoline powered) vehicles will almost certainly become widespread sooner than fuel cell–powered vehicles. Diesel has been reasonably successful in Europe because of high taxes on gasoline, but the United States has chosen not to adopt that policy, and diesel penetration remains below 1 percent. However, elevated gas prices could improve opportunities for sales of diesel vehicles in the U.S. High-mileage drivers in particular can realize significant savings with a diesel vehicle. So can drivers of heavy vehicles such as vans, pickup trucks, large cars, minivans, and SUVs. This alone could push diesel penetration in the United States into the 30 percent range within 10 years.

For this to happen, though, diesel engines will have to meet stringent emissions tests. U.S. regulations that took effect in 2004 require that by 2007, diesel engine nitrogen oxide emissions be reduced by 93 percent and particulate matter emissions be reduced by 90 percent. In addition, the government stipulated that carbon monoxide emissions from diesel vehicles be at the same level as those from gasoline vehicles. Although these standards will increase the cost of making and selling diesel vehicles in the U.S., we believe that the opportunity to tap the large market that has been buffeted by high gasoline prices will convince global automakers to refocus their sights on diesel engines.

In some ways, hybrid cars represent an even more attractive alternative than diesel. Hybrids achieve 30 to 60 percent better fuel economy (in city driving) than nonhybrid versions of comparable gas-powered vehicles, whereas vehicles powered by diesel fuel typically achieve 30 percent better fuel economy (in all conditions) than their gas-powered counterparts. Furthermore, because hybrids are fueled with gasoline and can make use of existing infrastructure, they are more convenient than diesel automobiles, since diesel is available in only about one-third of retail fuel outlets in the United States. Studies have shown that 50 percent of all fuel consumers say that convenience is their primary purchase consideration. And unlike diesels, hybrids do not raise concerns among consumers about cleanliness and noise.

However, hybrids are expensive, selling for at least $3,000 more than comparable conventionally powered cars. The extra engineering required to “hybridize” a regular power train ranges from moderate to gigantic (sophisticated power train controllers, a million lines of software code, and “power electronics” in the black box). The cost of this will only come down with economies of scale. Consequently, even with fuel prices as high as $3.50 per gallon, only the highest-mileage consumers would be expected to switch to hybrids. This will limit U.S. hybrid penetration to less than 10 percent over the next decade. For the short term, at least, diesels seem to be a better value for most U.S. consumers, whereas hybrids seem to be a better value in some European markets, particularly because of the congested, stop-and-go driving in such large cities as Paris, Rome, and London.

Currently, Japanese and European manufacturers are best prepared to meet this changing auto environment. They have the lead on hybrid and diesel power trains; they also have more rapid design cycles and are more capable of rolling out new fuel-efficient designs as needed. Meanwhile, some lesser-known companies could benefit from changes in market demand. For instance, smaller car manufacturers, such as France’s PSA Peugeot Citroën, might enter the North American market with diesel technologies and small and medium-sized cars. Market shifts could also allow for the emergence of another creditable set of auto manufacturers from nations like China or India.

Over the next couple of years, automakers and their hundreds of suppliers will make sizable expenditures to meet these expected shifts in vehicle sizes, types, and power trains — whether the shifts are to diesel production and development of hybrid technologies or more exotic alternatives. Manufacturers will need a nimble and rigorous view of the marketplace to make these expenditures pay off.

Often, executive instincts are off the mark during changing times. Executives must shift from a progressive strategic-planning process to a more economically rigorous plan that outlines clear behaviors for anticipating the unexpected, both to seize opportunities and to fend off unforeseen threats. We already see the shift occurring from high gas prices. Are you ready to make the right bets, moment by moment, during this dynamic time?

Author Profiles:

Bill Jackson ([email protected]) is a senior vice president with Booz Allen Hamilton in Chicago. He works on major organizational change programs, including restructurings, post-merger integrations, and growth, for a variety of industrial clients, especially in the global automotive industry.John Loehr ([email protected]) is a senior associate with Booz Allen Hamilton in Chicago. He specializes in product strategy and innovation for automotive, aerospace, and other manufacturing companies.Natasa Azman ([email protected]) is an associate with Booz Allen Hamilton in Chicago. She works with automotive, consumer, and media clients on organizational strategies, business process redesign, and various strategic issues involving financial modeling.

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